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That said, you can use the box spread rules to determine which is more cost efficient to liquidate the position. Say if the forecast direction is still on track but the magnitude of the move is underestimated, the trader would adjust and roll the strike further towards the forecast direction to continue participating in further price movement of the underlying. Note that you need a vertical spread 2 legs to roll a covered call 1 leg. Here we need a butterfly 3 legs to roll a vertical spread 2 legs. As illustrated below, what it actually does is liquidate the original positions and then initiating a new vertical spread where the lower strike becomes the higher strike rolling down , vice versa.
That is, such adjustment is expensive as it requires initiating 4 times the number of options. Again, the liquidation process is same as the exit strategy where a synthetically equivalent spread can be used to liquidate the original position, and the choice of whether to use call or put spread to roll the spread further in forecast direction depends on the box spread value and liquidity. An unhedged collar is quite similar to bull vertical spreads where you buy the option of lower strike, sell the option of higher strike, both of the same expiration cycle, except that the lower strike option is a put and the higher strike is a call.
That said, if underlying is in between both strikes, both put and call are OTM. An unhedged collar is a bearish spread where, unlike bear vertical spreads that limits the risk at extreme upside and downside risk, it limits the risk around the underlying price and has unlimited risk. Typically, unhedged collars are structured so that the total cost of the spread is near zero. That is, the two options are approximately ideally equidistant from current underlying price so that they carry approximately the same premium.
However, factors such as a backwardation forward curve equity dividends, positive FX swap rate will favor calls over put as strikes are adjusted lower corresponding to the underlying, or a reverse IV skew that results in OTM put being more expensive than equidistant OTM call.
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Likewise, an unhedged reverse-collar is quite similar to a bear vertical spread, except it sell a lower strike OTM put and buy a higher strike OTM call, resulting in a bullish spread. On the far downside, a collar becomes a long put as the call sold expires worthless. On the far upside, a collar becomes a short call as the put bought expires worthless. However, the behaviour of the Greeks in between the strikes, ranges of IV or over time is interesting. In other words, selling a put instead of a call in a reverse collar allows you to capture the upside risk with the long call as the delta of a short put is positive rather than negative if short call , while the other greeks theta, vega remains unchanged for a short option.
So if you are forecasting a strong upside directional movement in the underlying, but concerned that timing may be off and do not wish to incur paying the cost of an outright call option , you will still long a call at a higher strike resistance where breakout occurs but also, sell a put at an equidistant lower strike to mitigate the cost of buying an option and an off timing issue.
That said, for this to work, you should also be confident that the underlying will never go below the lower put strike support of the reverse-collar such that the writing the option is only to your favor. Likewise, buyer of a collar should be expecting a strong downside directional movement below the lower put strike. Sensitivity to underlying is soften if there is a greater time to expiration. Resulting delta profile is similar to a bull vertical spread. An ATM option with a longer time left to expiration will have a higher gamma. Gamma is same for call and put , but positive for a long option inverse to negative theta since delta converges faster to delta when option is increasingly ITM.
Gamma profile is similar to bull vertical spread where since its a long put option at lower strike and short call option at higher strike. That is, gamma peaks at lower strike, troughs at higher strike since short option and highest when ATM. Same profile for vega since a long option have positive gamma and positive vega, while inverse profile for theta.
Vice versa for a reverse-collar, where greek profiles are similar to a bear vertical spread since its a short put option at lower strike and long call option at higher strike. It is cheaper to long a reverse-collar when delta RR is negative and if you think that the reverse volatility skew is overly extreme and would revert to a less skewed smile. In other words, if the market is overly concerned of a downside risk, the risk is then reversed to the upside , since upside is unlimited and the downside or the cost of OTM calls is diminished, resulting in a higher return-to-risk favoring the upside.
Vice versa, a positive delta RR favors a long collar position. What if the open ended risk from the option sold materialise when the strong pivot levels you position yourself fail to hold? You would need stop-loss orders to mitigate the unlimited risk of the short option leg. Trade management for hedging wrapping collar on underlying position and directional strategy collar only are of different motivation and should be handled differently. When the collar strategy is successful, you actively manage the long option component directional strategy to squeeze the maximum profit out.
Ideas are cheap, execution is everything – Part I – No Noise Only Alpha
Options have a asymmetrical floored payoff and that means profit taken off the table is taken off. Only downside is the execution cost to sell the vertical spread in order to lock in profit but in return, gives you more holding power. Say you are bearish with a collar and the long put is ITM. Underlying broke below support put strike. You roll down the ITM long put strike by selling a bear pull vertical spread with the higher strike at the long put lower strike. Close residual open ended risky short call given its further OTM. For example, if you think 95 is the next support level where price will consolidate before the next breakdown, 95 will be the lower strike of the put vertical spread.
Say you are bullish with a reverse collar and the long call is ITM. You roll up the ITM long call strike by selling a bull call vertical spread with the lower strike at the long call higher strike.
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Close residual open ended risky short put given its further OTM. For example, if you think is the next resistance level where price will consolidate before the next breakout, will be the higher strike of the call vertical spread. When the collar strategy is unsuccessful, you actively manage the short option component hedge. Typically, such risk management is done before entering the trade. You would place a stop order right below the key support put strike in a reverse collar or right above the key resistance call strike in a collar.
This level is an additional stop to reduce your open ended risk in the event that your forecast direction turn out wrong. In the event of holidays occuring before expiration of strategy, if there are major news on the day of the holiday, gapping through stop loss level mean that stop orders are not executed. Depending on whether if there is any value left for the long option, you can either hold it as a lottery ticket or close it to salvage any value remaining.
What you Get
Vice versa, to extend more time to a reverse collar, you would want the further expiration legs of the calendar spreads to be long call, short put, where put is always of the lower strike. That is, sell put calendar spread of lower strike, buy call calendar spread of higher strike. Since wrapping a collar around a long underlying transforms position into a synthetic bull call vertical spread, it also needs management as underlying price changes. The collar lower put strike will be the lower strike of the call vertical spread.
That said, if underlying is near , a key resistance, and you think underlying will correct to When underlying falls to That is, the put bought at Yes, it is counterintuitive against the expectation of a breakdown below collar put strike since you are long the underlying , and it transforms the position into a bull vertical near the higher strike, and liquidates the collar to transform back to underlying only when it falls near the lower strike — that is, counterintuitively being bullish near the resistance and capping further upside at resistance so as to earn more credit. Vice versa, you wrap a reverse-collar around a short underlying transforms position into a synthetic bear call vertical spread when underlying is near its support and unwinding the reverse-collar when underlying rebounds back to resistance — that is, sell a put with strike at support, buy a call at resistance, then closing these options at a better valuation when underlying rebound.
To simplify, since a collar structure is bearish, you buy collar when underlying tops and sell the collar when underlying falls, or you sell collar bullish when underlying bottoms and buyback the collar when underlying rises. That is, it sells nearer the money synthetic call vertical spread, then buys them back when vertical is further from the money. The counterintuitive part is that collar is initiated when collar is close to being OTM and unwind before collar becomes ITM.
Long straddles or strangles are used when the trader is forecasting a large magnitude move in the underlying in either direction intrinsic value of options moving ITM due to a change in underlying price or an overall increase in IV base levels rise in extrinsic value of options bought.
Vice versa, short straddles or strangles are used when the trader is forecasting little to no directional movement in the underlying and seeks to profit from a decrease in the overall value of the position due to time decay or falling IV which will lead to a decline in extrinsic value of options sold. Long strangle is a 2 leg spread that simultaneously buys both a call and a put at the same strike price , typically both at 50 delta ATM since the trader does not have a clue on the direction.
Maximum profit is unlimited to the upside with a symmetrical payoff that results in profit regardless of direction.
Long strangle is a 2 leg spread that simultaneously buy a call and a put but of different strikes , where typically, both are OTM and equidistant from current underlying price since the trader wants to be delta neutral e. Strangle is preferred over straddle sometimes to be cheaper to execute since ATM options are way expensive to initiate the straddle i.
Payoff structure is similar to a straddle, except that its maximum loss or upfront debit to initiate the strategy is cheaper, but it has a larger range where it does not breakeven since put strike is lower, call strike is higher. Vice versa, since payoff is symmetrical, for the writers who simultaneously write these options, will inherit the maximum loss of buyers as maximum profit credit for taking his bi-directional risk while taking unlimited maximum loss floored at underlying price at 0 if its not a derivative. Breakeven price range is the same as it inherits as a counterparty to the buyer.
Why straddle at the same strike or strangle at strikes equidistant from the delta 50? Delta ranges from to with a higher gamma steeper delta slope between breakeven prices and highest positive gamma when at strike. Similar with all options, with more time to expiration, the sensitivity of greeks over strikes will be smooth out over time as more possibilities could happen.
Ideas are cheap, execution is everything – Part I
Likewise, buying 2x options will have 2x negative theta given the 2x debit paid on initiating and theta is most negative when underlying is at the strike. Vice versa, selling these strategies will have a direct opposite greeks profile. Long Strangle — Vega is much higher and less accentuated at OTM strikes with longer days to expiration. Since straddles and strangles are spreads that capitalize on large movement or lack thereof for writers in the underlying stock or index, volatility is key to the success or failure of these strategies. That is, these strategies have large positive vega or negative if writing these strategies.
Remember that vega is very sensitive to time until expiration of the options and vega is greater when there is more time to expiration. That said, how early the kink appears at the event depends on the market coverage on the issue and the experience of the market to come out with a baseline scenario for the event.
Of course, strangles are sought after as cheaper alternatives to straddles when the base IV is elevated, resulting in higher IV across strikes. And since calendar spreads is an alternative strategy to trade a rising IV view around a specified period, the IV surrounding the specified date will rise accordingly, resulting in a smoother kink in the term structure.